Edited version of your private ruling

Authorisation Number: 1012454413195

Ruling

Subject: Non arm's length non-commercial loan interest

Question

Are you entitled to claim a deduction for the interest incurred on a loan?

Answer

No

This ruling applies for the following periods

Year ended 30 June 2009

Year ended 30 June 2010

Year ended 30 June 2011

Year ended 30 June 2012

The scheme commences on:

1 July 2008

Relevant facts and circumstances

You lent funds through a bank loan facility to a private company (the 'Borrower'). You were not a shareholder of the Borrower. The Borrower had five shareholders, including your domestic partner.

The loan facility was a standard investment home loan, secured against your rental property. The repayment period was 25 years, with interest only repayments for the first 5 years. The only obligation of the Borrower was to repay the loan at cost.

The Borrower only made a few of the required repayments, prior to being liquidated. You did not return any of the repayments as interest income in your tax returns.

Relevant legislative provisions

Income Tax Assessment Act 1997 Section 8-1

Reasons for decision

Section 8-1 of the Income Tax Assessment Act 1997 allows that interest is deductible to the extent that it is incurred in gaining or producing assessable income or in carrying on a business for that purpose, except to the extent that the expense is of a capital, private or domestic nature or incurred in gaining or producing exempt income.

Taxation Ruling TR 95/25 states interest expense must have a sufficient connection with the operations or activities which more directly gain or produce the taxpayer's assessable income and not be of a capital, private or domestic nature; that the test is one of characterisation and the essential character of an expense is a question fact to be determined by reference to all the circumstances.

Whether interest has been incurred in the course of producing assessable income generally depends on the use to which the borrowed funds have been put. The 'use' test, established in the High Court of Australia case of Federal Commissioner of Taxation v Munro (1926) (1926) 32 ALR 339; (1926) 38 CLR 153, is the basic test for the deductibility of interest and looks at the application of the borrowed funds as the main criterion.

Further, in the Federal Court case of St George Bank Ltd v Federal Commissioner of Taxation 2008 ATC 20-018, it was held that the character of the advantage sought by the making of the expenditure is the chief, if not critical, factor in determining its deductibility. Allsop J said:

There are, I think, three matters to be considered, (a) the character of the advantage sought, and in this its lasting qualities may play a part, (b) the manner in which it is to be used, relied upon or enjoyed, and in this and under the former head recurrence may play its part, and (c) the means adopted to obtain it; that is, by providing a periodical reward or outlay to cover its use or enjoyment for periods commensurate with the payment or by making a final provision or payment so as to secure future use or enjoyment.

Taxation Ruling TR 95/33 discusses the relevance of subjective purpose, motive or intention in determining the deductibility of losses and outgoings. It states:

4. …if the outgoing produces no assessable income, or the amount of assessable income is less than the amount of the outgoing, it may be necessary to examine all the circumstances surrounding the expenditure to determine whether the outgoing is wholly deductible. This may, depending on the circumstances of the particular case, include an examination of the taxpayer's subjective purpose, motive or intention in making the outgoing.

5. If, after weighing all the circumstances, including the direct and indirect objectives and advantages, in a commonsense and practical manner, it can be concluded that the expenditure is genuinely, and not colourably, used in an assessable income producing activity, a deduction is allowable for the loss or outgoing.

6. If it is concluded that the disproportion between the outgoing and the relevant assessable income is essentially to be explained by reference to the independent pursuit of some other objective (e.g., to derive exempt income or the obtaining of a tax deduction), then the outgoing must be apportioned between the pursuit of assessable income and the other objective: see Fletcher at 91 ATC 4957-8; 22 ATR 621-3.

Taxation Ruling IT 2167 is about non-economic rental cases. It provides for rental cases that are not consistent with normal commercial practices, as a working rule, income tax deductions for losses and outgoings incurred may be allowed up to the amount of assessable income received.

In your case, our view is the essential character of your expenditure did not have a sufficient connection with operations or activities which more directly gain or produce your assessable income. Nor did your expenditure have a sufficient connection with any investment activity expected to produce assessable income.

You did not carry on a business of money lending. You were not a shareholder of the Borrower. There was no gain or profit to be made from the interest expected to be repaid by the Borrower. In short, your arrangement with the Borrower was not at arm's length and was not consistent with normal commercial practices in this area.

The impression gained is the essential character of your expenditure was of a private nature, that is, related to a personal favour you provided to the Borrower rather than related to receiving a direct financial reward or return.

Paragraphs 13 and 16 of Taxation Ruling IT 2167 provides for cases that are not consistent with normal commercial practices, as a working rule, income tax deductions for losses and outgoings incurred may be allowed up to the amount of assessable income received. This is also consistent with the principles of Taxation Ruling TR 95/33.

In conclusion, we consider you entered into a non-arm's length non-commercial arrangement to on lend borrowed funds, as a personal favour, to the Borrower. As the relevant expenses incurred were not related to any commercial income earning activity, deductions for losses and outgoings incurred may be allowed up to the amount of assessable income received.

As you received insignificant interest repayments from the Borrower, for the most part, no deduction is available to you. As you did not return the interest you received any deduction available to you, will not change your taxable income.